By Timour Chayipov and Mark Bern, CPA CFA
In our original article titled, "A Chance to Make 50% on Apple With Little Downside Risk," we explained a strategy called an artificial buy/write strategy. On June 29th (the last day of market activity prior to publication of the article), Apple (NASDAQ:AAPL) stock closed at $584.00. The stock has risen by 14 percent since that time to close at $663.22 as of the close on Friday, August 24, 2012. Thus far our strategy is up a nearly identical 15 percent, even though we only used $20,000.
We are writing this article to help substantiate the viability of this strategy versus buying the stock. One thing that makes this strategy better, at least in our opinion, is that stocks like AAPL become more affordable. But the biggest reason is the difference in the risk versus owning the stock. If one had bought AAPL at $584 at the end of June that investor could have suffered losses had the stock dropped below that level at any point. They still could. But, with our artificial buy/write strategy, the investor would not risk losing money until the stock price dropped below $400. That is because the investor would not actually own any AAPL stock until the price dropped to that level.
We sold a January 2014 put option with a strike price of $400 which would obligate us to buy 100 shares of the stock at a price of $400 a share. We also bought two January 2014 bull call spreads with $600/650 strikes. We collected $38 for selling the put option and each bull call spread cost us $19, so we simply used the premium from selling the put to purchase the bull call spreads. The $20,000 investment is represented by the cash required in our account to secure the put option contract. For more detailed explanations on how we set up the trade please see the original article linked above.
As of the close of the market on Friday, August 24, 2012, the put option could be bought back for $18.85 a share which means we are ahead on that end of the trade by $1885. The spread option now has a profit of $5.55 per spread. We bought two spreads giving us an unrealized profit thus far of $1,110 on that portion. The total unrealized profit to date is $2,995 which works out to a return of 15 percent, or better than holding the stock and with less downside risk.
Another great feature of this strategy is that once we have picked up at least 50 to 60 percent of the potential profit we will most likely unwind the trade and take that profit. We can stand aside and wait patiently for the next opportunity to enter a new position with a similar risk / reward profile. It has been less than 2 months and we are ahead of the stock in terms of appreciation. We won't collect the dividend, but we could sell calls against our spread position to collect more premiums to compensate for the lack of dividends if we desired to do so. But we believe that this position will yield us the profit of 25 percent to 30 percent we want within the next few months so we'll probably take our profits at that point. There were several commenters who felt we were crazy to expect to get that much within the first six months of the trade, but here we are at less than two months and already half way there!
Why would this strategy appreciate faster that the stock? This is the other reason for writing this article. There are two reasons why this happens. The first is that as the time to expiration shortens, a portion of the premium called the time value premium decays. If the stock remained at the same price over the entire period, the trade would still work, but much more slowly, and we would make money while the stock did not appreciate. We really like that part. The other piece occurs on the put side of the trade. It only happens when the price increases, but in this case (just as we expected) AAPL stock rebounded after a bad quarterly report on higher expectations surrounding the release of the iPhone 5. As the price of the stock appreciates the premium on the put option falls rapidly and gives us some profit early that was not calculated into the original profit profile. The further the stock price rises above the strike price of the put the lower the premium we would need to pay to buy it back as we unwind the position. All of that reduction in premium is pure profit. To understand the original profit calculation, please refer back to the original article.
Remember that we sold the put option in order to use the premiums collected to purchase the bull call spread options position. Those two premiums offset each other minimizing our out of pocket expense to zero. But now we are seeing gains in both positions as the stock price increases.
Finally, we want to explain what we expect to see happen with AAPL stock over the next few months. As many of you know there is a saying in the investing circles that we should "buy the rumor and sell the fact." What this means is that prices move up on expectations ahead of any actual event if that event is expected to provide positive results. The reverse is true of negative expectations where we would "sell the rumor and buy the fact." The point here is that the market is expecting that AAPL will release the new version of its iPhone (iPhone 5) in September and that sales will be spectacular. Even if that happens it is likely that, unless the results reported in October (July-September quarter) beat raised expectations the stock is likely to tumble when the actual (fact) results are reported. During the next few weeks it is likely that additional rumors will unfold around the iPhone 5 release which could easily drive AAPL stock up near $700 per share. At that point we should have captured enough of a gain to make it worth our while to take profits and stand aside for the next pull back when we will recommend another similar position, but probably at a somewhat higher level.
If expectations are exceeded and the stock price does not increase enough before the next quarterly report we will have to wait for more rumors in the fourth quarter before taking profits. But even in that scenario we should still be able to catch a gain of near 30 percent in less than six months (or 60 percent of the total potential gain over the full 18 month period from the start of the trade to expiration). We also feel that due to the volatility of AAPL stock there should be one or more additional opportunities to make similar gains between now and January 2014. It is not that we are greedy. Rather, we want to show investors who may be new to the many uses of options a few methods that can help optimize return potential without taking on undue risk. We hope you will follow our work so you won't miss our recommendations when we see those opportunities arise. With the market at a relatively high level by certain measures, we do not see much in the way of opportunities at the moment. But we will write about the opportunities as each one we identify reveals itself to us in the future.
We also explain how to use the strangle strategy to increase yield from an existing portfolio of stocks in "Our Long-Term, Investing for Yield Strategy" Part 1 and Part 2. Don't forget to read the comment sections because the questions and answers always add a great deal of additional information. The open communication and sharing of experiences through comments is one of the great things about Seeking Alpha.
We hope that your find our articles interesting an informative. Thanks for reading!
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.